Small Business Finance

Using Equity, Debt, and Gifts

Chapter 15

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 Learning Objectives

LO1 Describe the three types of capital

financing and their costs and trade-offs.
LO2 Explain the characteristics of a business
that determine its ability to raise capital.
LO3 Determine the best type of financing for
your business.
LO4 Describe the differing needs for
financial management at each stage of
business life.

15-2
Sources of Financing for Small
Businesses
 The number one source is from the
owners (or potential owners)
themselves.
 The other major sources include
family and friends, credit cards, trade
credit, banks, and other commercial
lenders.

15-3
Sources of Financing for Small
Businesses
 Debt
– A legal obligation to pay money in the
future.
 Equity capital
– Money contributed to the businesses in
return for part ownership of the
business.

15-4
Sources of Financing for Small
Businesses
 Gift
– Valuable assets or services donated to
the business without any obligation to
repay or give up any ownership interest.
 Debt capital
– Money borrowed for the purpose of
investment in a business.

15-5
 Financing with Equity

 Outside equity
– Money from selling part of your business
to people who are not and will not be
involved in the management of the
business.

15-6
 Question

Which form of business is a legal

“artificial” entity that is formed by
filing specific documents with a state
government?
A.Sole proprietorship
B.Partnership
C.LLC
D.Corporation

15-7
 Legal Forms of Business

 Partnership  Corporation
– Two or more – A legal “artificial”
people entity that is
cooperating to formed by filing
conduct a specific
business documents with a
enterprise. state government.

15-8
 Legal Forms of Business

 Limited liability company (LLC)

– A legal form of business organization
that is created by filing required
documentation with a state government.
– have a choice, under federal tax law, of
being taxed as either corporations or
partnerships.

15-9
 Legal Forms of Business

 Limited partnership
– A legal form of business organization
that is created by filing required
documentation with a state government;
– one or more partners may have no
liability for the debts and actions of the
partnership.

15-10
 Legal Forms of Business

 Sole proprietorship
– A business owned by a single individual
who is responsible for all debts and
claims against the business.

15-11
Legal Forms of Business

15-12
 Getting Equity Investment
for Your Business
 Interest  Dividends
– A charge for the – Payments of
use of money, profits to the
usually figured as owners of
a percentage of corporations.
the principal.

15-13
 Getting Equity Investment
for Your Business
 Gain on investment
– The percentage amount that the payout
of an investment differs from original
cost
– Calculated as (payout − investment +
dividends)/ investment.

15-14
 Equity Capital from the
Investor’s View
 Risk
– The level of probability that an
investment will not produce expected
gains.
 Diversify
– To invest in multiple investments of
differing risk profiles for the purpose of
reducing overall investment risk.

15-15
 Equity Capital from the
Investor’s View
 Owners and investors want to make
money
– Lenders expect a return on this money
 To get money from other people, you’ve
got to show them that your business
probably can make gains for them
 Growth potential is a primary concern for
equity investors

15-16
Equity Capital from the Owner’s
View
 Financing with equity is (1)
expensive and (2) guaranteed to
create problems of control and
decision making.
 Suppose you sell half your business to
raise capital. You have just sold half of all
your future profits, half of all your future
growth, half of all your future wealth.

15-17
 Why Use Equity Capital?

1. You will reduce your own exposure to

financial loss
2. Your business will not have increased
costs in the form of interest
3. Bringing outside investors into an existing
business can often reenergize it by
providing new ideas, procedures, and
processes

15-18
Financing with Debt: Getting a
Loan for Your Business
1. Direct loans of cash
2. Guaranteeing loans made by
commercial banks
3. Reducing taxes by allowing interest
to be deducted

15-19
Financing with Debt: Getting a
Loan for Your Business
 Community development
organization
– An organization authorized by the SBA
to make insured loans to small
businesses that are expected to increase
economic activity within a specific
geographic area.

15-20
Financing with Debt: Getting a
Loan for Your Business
 Small business investment
companies
– Private businesses that are authorized to
make SBA insured loans to start-ups and
small businesses.

15-21
 The Four Cs of Borrowing

Figure 15.1

15-22
Financing with Debt: Getting a
Loan for Your Business
 Accelerator
– An organization that supports startup
technology businesses by providing
inexpensive office space, a variety of
support services, and resources
– most are associated with universities.

15-23
Financing with Debt: Getting a
Loan for Your Business
 Credit reporting agency
– A business that collects, collates, and
reports information concerning an
entity’s use of debt.
 Fair Credit Reporting Act
– U.S. federal legislation specifying
consumers’ rights vis à vis credit
reporting agencies.

15-24
Financing with Debt: Getting a
Loan for Your Business
 Collateral
– Something of value given or pledged as
security for payment of a loan
– may consist of financial instruments,
such as stocks, bonds, and negotiable
paper, or of physical goods, such as
trucks, machinery, land, or buildings.

15-25
 Gift Financing

 Tax abatement  Tax credits

– A legal reduction – Direct reductions
in taxes by a in the amount of
government. taxes that must
 Grants be paid,
dependent upon
– Gifts of money meeting some
made to a legal criteria.
business for a
specific purpose.

15-26
 Gift Financing

 Economic development agency

– A government organization that works to
increase economic activity in the form of
job opportunities within a specific
geographic area.

15-27
 Gift Financing

 Foundation
– An institution to which private wealth is
contributed and from which private
wealth is distributed for public purposes.

15-28
 Forms of Personal Gifts

Exhibit 15.1

15-29
 When Giving a Gift

1. Put your agreement into writing

2. If it is a gift, have the agreement
specifically say so.
3. If it is a loan, have the agreement specify
the exact interest and payment terms.
4. If it is an equity investment, consider
nonvoting stock.

15-30
What Type of Financing Is Right
for Your Business?
 Cost of capital
– The percentage cost of obtaining future
funds.
 Weighted average cost of capital
(WAC)
– The expected average future cost of
funds.

15-31
What Type of Financing Is Right
for Your Business?
 Financial leverage
– A measure of the amount of debt
relative to total investment.
 Optimum capital structure
– The ratio of debt to equity that provides
the maximum level of profits.

15-32
 Interaction among Profitability,
Control, and Risk

Figure 15.2

15-33
Owner’s Return on Equity

15-34
Tools for Financial Management

The obvious comparisons:

 With your planned position and
results (your master budget)
 With prior years’ position and results,
 With the position and results of other
firms.

15-35
Financial Management for Start-
Up
 During the start-up phase of a small
business the primary financial
management need is to obtain
sufficient funds to pay for equipment,
buildings, inventory, and indeed, all
the costs of starting and running a
business.

15-36
 Financial Management for
the Life of Your Business
 Accredited investors
– The SEC’s term for individuals with a net
worth greater than $1 million or a
personal annual income of at least
$200,000 in each of the two most recent
years
– who are therefore qualified to make
private equity investments in
businesses.

15-37
The Pecking Order of Funding
Sources for New Firms

Figure 15.4 15-38

 Use of Debt and Equity
in Start-Ups from the PSED

Figure 15.5

15-39
Types of Angel Investment

15-40